Fidelity Viewpoints Workplace Edition  07/25/11

Tips to help protect your investments against inflations corrosive effects.

If youve been anywhere near a gas pump or a grocery store lately, youve probably experienced significant sticker shock. Food and energy prices have been steadily rising the past few months, driven by rising consumer demand in emerging markets and concerns with supply disruptions.

Although you can easily see how inflation erodes the purchasing power of your money while you run errands, understanding how it affects your portfolio may not be as obvious. But the impact of inflation on your portfolio can be just as corrosive, whatever your age.

No matter if youre saving for retirement or are in retirement, when inflation erodes purchasing power, you need more dollars to pay for the same goods and services, says Derek Young, chief investment officer for Fidelitys global asset allocation division. Thats why its critical for investors to dedicate a portion of their assets to help offset an increase in inflation.

Although investors should always be mindful of inflations effect on their portfolios, Young says its particularly important to pay attention now. Like many investment professionals, he believes, a combination of loose monetary policy, massive fiscal deficits, and surging demand for commodities in emerging markets have set the stage for rising inflation in the years ahead.

How inflation has eroded the value of a dollar over time.

As you can see in the chart below, inflation has steadily eroded the purchasing power of the dollar over time. Even though inflation was relatively low during the decade ending Dec. 31, 2010, it cut the buying power of a dollar to just 82 cents, as measured by the CPI. 1

Growing inflationary pressures on the horizon

While inflation in the United States has been modest for years, a number of factors suggest it may be on the rise. According to the Consumer Price Index (CPI), U.S. inflation measured 2.2% for the 12 months through February, 28, 2011. This figure reflects an increase of 0.5% over the previous month, driven in large part by the increasing cost of both energy and food. 2

Currently, U.S. inflation is modest as compared with rising prices abroad, especially in the emerging markets known as the BRIC nationsBrazil, Russia, India, and China. As of January 2011, inflation was 6% in Brazil, 9.6% in Russia, 8.2% in India, and 4.9% in China. 3 And in these countries, the increases are being driven by more than just food and energy. Wages are increasing too, and this has an additional inflationary impact, Young says.

But, he says, economic trends in foreign countries can often spill over to the U.S. so they bear watching. Central banks in all four of the BRIC countries have increased interest rates since the beginning of 2011. In the U.S. by contrast, the federal funds rate remains extremely lowthe Federal Reserve set the target rate at 0 to 0.25% in December 2008, and hasnt changed it since then. According to Young, the contrast between the low rate in the U.S. and the markedly higher rates overseas suggests inflationary pressure is building.

Whats more, he believes the Fed is unlikely to raise ratesand relieve some of that pressureuntil it sees significant improvement in the job and housing markets. But this could create a Catch-22. If the Fed begins to increase rates, this could have a negative impact on the housing market and future hiring, he says. But the slower the Fed is in responding to inflation, the more inflationary pressure builds up.

The Feds two rounds of quantitative easing since 2009 stimulated the economy and helped stabilize financial markets, but brought on additional inflationary pressure. The second round of quantitative easing, known as QE2, is scheduled to end in June, and Young says its unclear whether circumstances will warrant the deployment of a QE3, which could exacerbate the inflation situation even as it helps prevent economic deterioration.

I expect the Fed to be able to control inflation as long as the economy continues to grow, Young says. But, based on market expectations, I do think inflation will go upand remain positivein the U.S. At present, the relationship between prices in the conventional Treasury market and the Treasury inflation-protected securities (TIPS) market implies an annual inflation rate of about 2.65% over the next decade.

Even if the Fed is successful in keeping inflation closer to 2% over this period, the buying power of a dollar would decline to 82 cents as measured by the CPI (see chart above). The point is that even relatively low levels of inflationas compared with some of the double-digit, 12-month inflation numbers in the 1970scan significantly erode the buying power of the dollar.

What does it mean for your portfolio?

Inflation can impact your portfolios fixed-income and equity holdings in a number of ways.

Inflation is certainly a risk to conventional bonds. Because they have a fixed income stream, inflation can erode their purchasing power over time. For example, on April 12, 2011, the conventional 10-year Treasury note had a yield of 3.5%, while the trailing one-year inflation rate was about 2.1%. If this rate of inflation were to continue, then in terms of purchasing power the 10-year notes so-called real yield would be 1.4% (obtained by subtracting the inflation rate from the Treasurys yield).

That is fairly low for a 10-year investment, says Bill Irving, portfolio manager for the Fidelity Inflation-Protected Bond Fund (FINPX). Furthermore, that real yield is not guaranteed, even if the security is held to maturity. As realized inflation rises, the real yield falls. For example, if the future inflation rate were to actually be (say) 3%, then the real yield of the 10-year note would drop to only 0.5%.

Inflation protection for bonds: Consider TIPS and I-bonds

Here are two ideas to help shield your fixed-income investments from inflation:

• Treasury inflation-protected securities (TIPS). Just like conventional notes and bonds, TIPS are issued by the U.S. Treasury and are backed by the full faith and credit of the U.S. government. Furthermore, just like conventional Treasuries, TIPS pay interest semiannually and return principal at maturity. The crucial difference between conventional Treasuries and TIPS is the way TIPS help protect against inflation.

To counterbalance the erosion of purchasing power, each cash flow of a TIP security is scaled up by the cumulative amount of inflationas measured by the Consumer Price Index for all Urban Consumers (CPI-U)from the security issue date to the cash-flow date. So TIPS provide a guaranteed real yield independent of the inflation rate, or in other words a nominal yield equal to the guaranteed real rate plus the future inflation rate, says Irving. For example, on April 12, 2011, the 10-year TIP security had a real yield of 0.85%. At first glance, that may not appear very attractive as compared to the current 3.5% nominal yield of the conventional 10-year Treasury note. But, at any future inflation rate greater than or equal to 2.65%, the TIP security ends up having a higher nominal yield.

Irving goes on to caution, however, that TIPS do have a few downsides: They dont provide the long-term growth potential that most retirement-oriented investors are looking for. And, says Irving, their prices can be quite volatile if you dont hold them until maturity. They also can generate taxable phantom income as your underlying principal adjusts for inflation, so you may want to consider holding them in a tax-deferred accountlike an IRA or a 401(k) plan. Despite the risks, Irving says, For all investors, including those over the age of 55, TIPS can play a valuable diversifying role in a portfolio while offering high credit quality and inflation protection.

Beyond bonds: commodities, stocks, real estate, and more

For those looking for investments beyond TIPS and I-bonds, Young says, commodities, equities, commercial real estate, and floating-rate loans have historically outpaced inflation; however, these investments may carry greater risk. They could potentially provide protection from inflation, but your specific allocation to each asset class may vary depending on your risk tolerance, age, and time horizon, he says.

Lets take a closer look at some of these potential inflation fighters:

• Commodities: Because increases in the cost of individual commoditieslike agricultural products, energy, and precious metalseventually flow through the production chain and drive up consumer prices, the commodities asset class, although it carries greater risk, can help provide both short- and long-term inflation protection. During the highly inflationary period from 1972 to 1980, commodities more than tripled the advance of inflation. 4 Commodities are the very foundation of our global needs for energy, food, and infrastructure. Rising commodity prices are often a source of inflation, so investing in this asset class can help offset the risk that inflation poses to a portfolio, says Joe Wickwire, portfolio manager of Fidelity Global Commodity Stock Fund (FFGCX) and Fidelity Select Gold Portfolio (FSAGX). Whats more, the commodity producers have the potential to generate solid returnseven when commodities dontbecause they generate cash flows, pay dividends, and can grow production. This was the case during the great financial asset bull market from 1982 through 2000. 5 But, commodities too can experience considerable volatility, especially in the short term.

• Equities: An allocation to equities has long been considered one of the most effective ways to outpace inflation: Stocks have outpaced inflation in every 20-year period from 1926 through 2009, effectively preserving investors purchasing power. 6 However, its worth bearing in mind that stocks have historically had a low correlation with inflation in the short term, making them a poor hedge against short-term changes in the Consumer Price Index. Whats more, the short-term volatility of stocks may make a significant equities allocation inappropriate for investors who are currently in retirement and who might not be able to sustain a short-term loss of capital.

• Commercial real estate: When inflation increases, commercial real estate tends to respond accordingly, with rents increasing for both office and retail spaces. This is due to the fact that changes in CPI are often factored into rent increases. In fact, real estate securities have outpaced inflation in 100% of the rolling 10-year periods since 1972. 7

• Floating-rate loans: Typically used by non-investment-grade companies, floating-rate bank loans offer investors higher income potential than investment-grade bonds. Theyre also linked to short-term interest rates: When short-term rates riseas they tend to do in an inflationary environmentthe value of floating rate loans rises, too. But companies that issue these loans are relatively risky bets, so these investments are not for everyone. Holders of floating rate loans are among the first in line to be paid in bankruptcy proceedings, but thats meaningful only if there are assets to recover.

Building your own portfolio inflation protection plan

• What to consider if you are under 55

If youre still saving for retirement, its critical to build a portfolio that seeks to provide the long-term growth necessary to fund two or more decades of retirementand protects your purchasing power. For this reason, Fidelity believes accumulatorsor those under the age of 55should consider significant exposure to equities. Commodities and real estate also may be particularly appealing to young people who are accumulating assets, Young says, noting that these securities can experience considerable short-term volatility.

Adds Irving, Investors under age 55 may want to consider owning TIPS as part of an overall diversified portfolio because they can offer high credit quality, inflation protection, and returns that have a low correlation to the returns of other asset classes.

Irving also says members of this age group may want to consider floating-rate securities if this asset class is consistent with their risk tolerance and investment objective. These pay an interest rate that resets periodically (e.g. monthly) and that is usually related to the stance of monetary policy, Irving says. In other words, the interest rate typically rises as the Fed gets more concerned about above-capacity growth and high inflation, and typically falls as the Fed gets more concerned about below-capacity growth and low inflation.

• What to consider if you are over 55

Retirees have to both spend money and factor in rising costs, Young says. As they get older, they may want to consider increasing their allocation to TIPS and floating-rate loans, while trimming allocations to riskier investments like commodities and real estate. For those who are more interested in enjoying their retirement-and less interested in managing their exposure to specific asset classesasset allocation funds that are aimed at providing a diversified approach to inflation protection may be a robust option as well.

But how much of your portfolio should you consider allocating to these types of investments? Young says that certain defined benefit plans, such as pensions, offer a reasonable road map to follow when investing for inflation protection. Defined benefit plans usually rely on a diversified combination of real-return asset classesoften around 10 percent to 15 percentaimed at providing inflation protection for a portion of their portfolios, 8 he says.

Another consideration for those over 55 may be to use a portion of assets to purchase a variable income annuity, 9 which can potentially help offset inflations eroding effect on your portfolio. This type of annuity is designed to generate a lifetime income payment, 10 along with the potential for that income stream to grow. It may be appropriate for people who are comfortable with fluctuating levels of income from month to month and want the opportunity to earn potentially higher levels of income over time to keep up with inflation.

While many people are drawn to traditional fixed annuities, which provide predictable income payments, there can be substantial benefits to including a variable income annuity in your overall income plan, says Roy Benjamin, vice president and actuary at Fidelity Investments Life Insurance Company. This type of annuity is showing increased popularly because it can help address the impact of inflation.

If youre in or near retirement and depending on your investments for income, you may be more sensitive to the effects of inflation and want to avoid a lot of short-term volatility.

Next steps

As you consider the ways in which you might protect your own savings from inflation, be sure to take your own risk profile, age, income needs, and other relevant circumstances into account. But whatever you do, dont delay.